Exit Strategies

Learn more about considerations to take when closing or selling a business.

Best Business Valuation Formula for Your Business

There are many approaches to take in establishing an accurate valuation for your business. Finding the best method for your situation will provide you with the best measure of value.

As you prepare to sell your business, you've taken a number of steps:

You've examined your company's historical financial statements.

You've carefully considered the prospects for future growth

You may have had your accountant recast your statements to reflect how new ownership would affect your company's earnings and cash flow.

You've also considered the market value of any real estate, equipment, inventory, and other hard assets that would be transferred in the sale, as well as the intangible aspects that make your business appealing.

Now, how do you boil all of this down into an asking price for your business?

In order to ensure that you get the best price for your business, it is wise to hire an expert business appraiser. The appraisal process can be very complex and time-consuming. It takes quite a lot of experience to do well.

There are a number of valuation methods that business appraisers have at their disposal, and even choosing the correct method (or more likely, the correct combination of methods) to use in a given situation is more of an art than a science. The following discusses the major approaches commonly used to put a price tag on small businesses. Our objective here is simply to give you high-level insights into the process that your appraiser will be go through.

Business valuation methods fall into the following categories, depending upon their major focus:

Asset-Based Valuation Focuses on Salable Parts

At a minimum, your company should be valued at the sum of the value of its easily salable parts. Two commonly used business valuation methods look primarily at the value of your hard assets.

Warning: If goodwill or other intangibles are a significant component of your business, relying solely on a salable parts method could could result in a serious undervaluation of the goodwill component of your business.

Book value. Book value is the number shown as "owner's equity" on your balance sheet. Book value is not a very useful number, since the balance sheet reflects historical costs and depreciation of assets rather than their current market value. However, if you adjust the book value in the process of recasting your financials, the current adjusted book value can be used as a "bare minimum" price for your business.

Liquidation value. Liquidation value is the amount that would be left over if you had to sell your business quickly, without taking the time to get the full market value, and then used the proceeds to pay off all debts. There's little point in going through all the trouble of negotiating a sale of your business if you end up selling for liquidation value — it would be easier to simply go out of business, and save yourself the time, broker's commission, attorney's fees, and other costs involved in selling a going concern. Thus, liquidation value is not even considered a valid floor for the price of your business (and you can use this argument in negotiations if you get an offer that approaches liquidation value.)

Historical Earnings Methods Are Commonly Used

In contrast to the asset-based methods, historical earnings methods
allow an appropriate value for the goodwill of your business over and
above the market value of the assets, if that's justified by your earnings. Although savvy buyers will be more concerned about the future
of your business than its past, predicting the future is difficult. The
assumption here is that your past history provides a conservative
indication of the amount, predictability, and growth trend of your
earnings in the future.

Most small companies are valued using one or more of the following
methods, all of which take into account the company's historical earning
power:

debt paying ability;

capitalization of earnings or cash flow; or

gross income multipliers/capitalization of gross income.

The starting point for all these methods is the recast historical
financials that show how the business would have looked without the
owner's salary and perks over and above
what a non-owner manager would be paid, non-operating or nonrecurring
income/expenses, etc. A judgment call must be made as to whether you
should look only at the last year's statements, or at some combination
of statement results from the last three to five years (the most common
combinations are a simple average, a weighted average that values the
most recent years more heavily, or a trend line that factors in the
percentage and direction of growth each year).

Debt-paying ability. This is probably the method most
commonly used by small business purchasers, because few buyers are able
to purchase a business without taking out a loan. Consequently, they
want to be sure that the business will generate enough cash to pay the
loan off within a short time, usually four to five years.

To entice a buyer, therefore, the price must be set at a point that
makes this short-term repayment possible. To determine the company's
debt-paying ability, you'd need to start with the historical free cash flow.
Free cash flow is usually defined as the company's net after-tax
earnings (with a reasonable owner's salary figured in) minus capital
improvements and working capital increases, but with depreciation added
back in. Interest on any existing loans is usually ignored, so that you
start with a picture of the company as if it were debt-free.

Next,
multiply the annual free cash flow by the number of years the
acquisition loan will run. From this amount, subtract the down payment.
The remainder is the amount available to make interest and principal
payments on the loan, and to provide the new owner with some return on
investment.

Example

Your free cash flow was $80,000 a year and it's reasonable to expect the loan to be repaid in four years,

4 x $80,000 = $320,000.

If the down payment were $80,000, then no more than $240,000 (or
$60,000 per year) would be available to make interest and principal
payments on the loan, and to provide the owner with some return on the
investment ($320,000 - $80,000 = $240,000. $240,000/4 = $60,000).

If the owner expected a 20 percent return on this $80,000 down
payment, that would translate to $16,000 per year, further reducing the
amount available to make debt payments to $44,000 ($60,000 - $16,000 =
$44,000).

An annual payment of $44,000 could support a four-year loan of
approximately $139,474.08 at 10 percent interest, or $145,733.58 at 8
percent interest. Add the loan amounts to the down payment, and you
arrive at a total purchase price of $210,685 at 10 percent, or $225,000
at 8 percent. If the lender is willing to finance the deal for a longer
term or a lower rate, a higher price would be possible.

Capitalization of earnings or cash flow. This is
another commonly used method. Basically, it involves first determining a
figure that represents the historical annual earnings of the company.
Generally this is EBIT (earnings before interest and taxes) but
sometimes EBITD (earnings before interest, taxes, and depreciation) is
used. Some buyers prefer to use free cash flow, as discussed above.

The chosen figure is divided by a "capitalization rate" that
represents the return the buyer requires on the investment in light of
the market rate for other investments of comparable risk. For example,
if the EBIT was $100,000 and the buyer required a return of 25 percent,
the capitalization of earnings method would yield a price of
$100,000/.25 or $400,000.

Gross income multipliers/capitalization of gross income.
Where expenses in a particular industry are highly predictable, or
where the buyer intends to cut expenses drastically after the sale (for
example, where the buyer is already in a similar business and can
centralize administrative functions), it may be reasonable to value the
business based on some multiple of gross revenues.

For example, some
service businesses can be valued at four times their gross monthly
income. A variation on this would be to divide the gross income figure
by a capitalization rate, as with the capitalization of earnings method
discussed above.

The problem with either of these methods is that they
ignore the fact that two businesses in the same industry with similar
revenues can have greatly different profitability margins, depending on
their expenses.

Dividend-paying ability. This method is listed by the
IRS as a possible valuation method for small businesses. However, in
practice it's rarely used for small, closely held companies. The reason
is that the ability of a small business to pay dividends is directly
dependent on its earnings, so it's usually more appropriate to look at
the earnings themselves. Furthermore, many small businesses try to
minimize their payment of dividends for tax reasons, so looking at the
company's past record of dividend payment is not a good indication of
the company's value.

One situation where it may be useful is if you're trying to sell a
minority interest in the company, and you want to show that there has
been a pattern of receiving dividends in the past. Minority interests in
closely held businesses are generally very difficult to sell, because
the owner usually can't force the payment of dividends or any other
corporate decision; showing a pattern of dividend payments may be a way
to make the interest marginally more marketable.

Assets and Earnings Valuation Often Used for Gift Tax Valuation

Assets and earnings valuation, known as the excess earnings method,
takes both assets and historical earnings into consideration in arriving
at the value of the business. This is the method prescribed by the IRS
for estate and gift tax situations when there's no other more
appropriate method. It can also be used in appraising a business that's
being put up for sale, although the IRS does not prescribe it for this
situation.

Since the IRS has sanctioned this method for at least some
purposes, your appraiser may want to use it also, particularly if you're
concerned about IRS scrutiny of your tax returns reporting the sale.
You may sometimes see this method referred to as ARM 34, which is what
the IRS calls it.

To use this method, you must first recast your historical financials
to show how the business would have looked without the owner's excess
salary and perks (that is, the amount over and above what a non-owner
manager would have been paid), non-operating or nonrecurring
income/expenses, etc.

For the income statement, a judgment call must be
made as to whether you should look only at the last year's statement, or
at some combination of statement results from the last three to five
years (the most common combinations are a simple average, a weighted
average that values the most recent years more heavily, or a trend line
that factors in the percentage and direction of growth each year). The
IRS prefers to see figures that represent a five-year average, which
seems to be a reasonable approach.

For the balance sheet, use the most recent month's sheet, recast to
reflect current market value. The starting point for the value of your
business is the net value of your assets as shown on the recast balance
sheet. But how much more should you get, based on the business's goodwill or intangible value?

Putting a price tag on goodwill. From your recast
financials you can determine your historical annual earnings figure
(generally, EBIT or earnings before interest and taxes). From this
you'll subtract the portion of earnings that's attributable to your
assets alone. Anything left over is the "excess earnings" — the portion
that's attributable to the going-concern value of the business.

How do you determine the portion of earnings that are attributable to
your assets? One way of looking at this is, if the assets were sold and
the money invested at market rates, how much could you get? How much is
the market paying for other investments of similar risks? This is one
of many areas where the expertise of a professional business appraiser
can be invaluable.

For example, your appraiser might say that, in view
of the risk involved in your particular business, your annual return
from the current assets should be about 150 percent of the rate of a
short-term government bond; your annual return from the long-term assets
should be about 188 percent of the bond rate.

After you compute the expected returns from your assets, compare the
total with your historical earnings figure. If the historical earnings
figure is higher than the return from assets, the difference is called
"excess earnings." The excess earnings can be divided by a
capitalization ("cap") rate to arrive at their value. Although a
professional appraiser will spend a good deal of time and effort
determining the proper cap rate to use, in today's market it will
generally be somewhere around 20 to 25 percent, or enough to recover
your investment in four to five years.

Example

Your recast balance sheet shows a net current asset value of $80,000,
and a net long-term asset value of $200,000. So, the minimum or base
price for your business should be $280,000 — the market value of your
assets.

Now let's assume that your historical annual earnings figure is
$150,000. How much of this earnings figure is attributable to the
assets? You might calculate that under current market conditions the
return on current assets should be $80,000 x 7.5% or $6,000, and your
return on long-term assets should be $200,000 x 9.4% or $18,800.

Using a cap. rate of 20 percent, the value of your excess earnings is
$626,000. Add to this the current market value of your assets, and you
arrive at a total price of $906,000 for the business ($626,000 +
$280,000 = $906,000).

Larger Companies Often Use Future Earnings Valuation

Theoretically, anyone purchasing a small business is interested only
in the business's future. Therefore, a valuation based on the company's
expected earnings, discounted back to arrive at their net present value (NPV), should come the closest to answering the buyer's questions about how much the business is really worth today.

That's the theory. However, in practice, valuations based on future
performance of the company are the most difficult to do because they
require the appraiser to make numerous estimates and projections about
what's around the bend. They are also the most time-consuming methods.
If inexpertly done, future earnings methods can result in a target sales
price that's way off base.

Nevertheless, if you think that your most likely buyer is a larger
company, it may be worth while to have your appraiser use one of these
methods. If carefully done by an expert business appraiser, valuation
methods based on future earnings can result in setting the highest
reasonable price for your business.

Methods based on future earnings are very frequently used by larger
companies in either merger or acquisition situations. The large-company
acquisitions manager will understand the method behind the madness of
making so many predictions about the future. Moreover, large companies
are often "strategic buyers"
who are likely to accept a higher price for your company in any event,
provided that you can justify it. That being the case, why not set the
highest asking price that you can reasonably back up with some
mathematical formulas and pro forma (projected) statements?

Using the discounted cash flow method. How do you go
about setting a price based on future earnings? The first step is to
look at your recast financial statements. Working from these, your
appraiser will create projected statements that extend for five or more
years into the future. Each year's free cash flow will be determined
(some appraisers prefer to look at each year's earnings before interest
and taxes or EBIT). These projections should not assume any major
changes by the new owner, since you are trying to measure the company as
it exists today; the new owner doesn't want to pay you for the value he
or she hopes to add to the company!

Once you have done this, the projected free cash flow from each year
is discounted back to the present, to arrive at the net present value of
each year's cash flow. These NPVs are added up, to arrive at the total
NPV of the company's earnings for the near future.

Tools to Use

How do you compute NPV? The easiest way is to use a good financial
calculator. If you don't have one, or don't want to take the time to
learn how to use one, our Business Tools contains a simple "present value of $1" table that you can use to compute the NPV of your cash flows.

The key here is deciding which discount rate to use. The higher the
rate, the lower the answer you'll get as to the value of the company.
The discount rate must reflect the appraiser's best guess as to what the
market rate will be for investments of a similar nature over the next
five years. It should also factor in the buyer's expected cost of
capital (i.e., the interest rate on an acquisition loan) and the
expected inflation rate. Choosing the correct cap rate is perhaps the
most difficult task the appraiser must do — and perhaps the most
mysterious to the rest of us. Let's just say that expertise in this area
is one of the main things you're paying your appraiser for.

The next step in using the discounted cash flows method is to
determine the residual value that the company will have after the five
(or more) years of your projected statements. There are a number of
different ways of doing this, more or less precisely.

One of the easier
methods is to take the estimated cash flow from the last year you've
forecasted, and assume that level of cash flow will continue
indefinitely into the future. Obviously, this is a rather conservative
prediction because most buyers will want the company to continue to grow
after the next five years! But, at any rate, you can take the last
projected year's free cash flow, divide it by the discount rate, and
arrive at the company's perpetuity earnings value. This value becomes
the company's residual value, which can in turn be discounted to find
its NPV.

Finally, the NPV of cash flow from each of the projection years, plus
the NPV of the company's residual value after these years, is added up
to arrive at the present value of the business.

Example

Let's say that after doing your best to look into the future and
forecast the next five year's cash flow, you arrive at the figures in
column one. Assuming a 20 percent discount rate, you come up with the
following figures:

Cash Flow NPV

Year

Free Cash Flow

NPV at 20% discount

1

$ 80,000

$ 66,667

2

85,000

59,028

3

92,000

53,241

4

99,000

47,743

5

108,000

43,403

---------

$270,082

present value of
5-year cash flow

residual value* of
business at 5 years:

$540,000

217,014

---------

$487,096

total present value of company

========

*Note: the residual value was
computed by taking the fifth year's projected value and dividing by the
discount rate: $108,000/.20 = $540,000.

Merger Specialists Favor Market-Based Valuation Methods

Several business valuation methods are based primarily on the market
price for similar businesses at a given point in time. Business brokers
and mergers and acquisition specialists are more likely to favor these
methods, at least as benchmarks, since they have access to data about
recent sales and merger activity. Ideally, market-based methods should
be used in conjunction with an examination of earnings (historical or
projected) so that they can serve as a "reality check."

Comparable sales method. The comparable sales method
attempts to locate similar businesses that have recently sold in your
area, and uses those comparable sales figures to set a price for your
business, adjusting appropriately for differences. While widely used for
real estate sales, this method is difficult to apply to business
valuations because of the problems in gathering information about small
business sales and because of the unique character of each business.

Rules of thumb/industry averages. These are frequently
used by business brokers, based on their experience and on published
standards for their industry. For example, your broker may tell you that
lately your type of business has been selling for about four times the
gross monthly revenues.

However, a rule of thumb does not take into
account any of the factors that make your business unique, and using one
can result in setting a price for your business that's way too high or
too low. Nevertheless, small businesses are often sold at a price based
on rule of thumb, simply because it's a relatively fast, cheap method to
use, and because it will result in a price that seems reasonable to
buyers who have been looking around at a lot of similar businesses.

P/E ratios. The profit and earnings ratios of publicly
owned companies in your industry are widely available, and can often be
used to set and compare prices for large companies with liquid stock.
However, that's the point: these companies' stock is easily bought and
sold, and it's easy for any investor to buy publicly-traded stock in
many different companies.

Consequently, large-company stock commands a
premium (perhaps 35 to 70 percent) because it is much less risky than an
ownership interest in a small, closely held company. Also, remember
that purchasing a small business will usually tie up all the buyer's
funds and prevent him from diversifying his risk, which further
contributes to relatively low prices for small business interests. For
these reasons it's best not to compare the value of your small company
with the P/E ratio of a large one, at all.

Valuing Partial Interests in Business

Our discussion of business valuation methods assumes that you're
attempting to put a value on the entire business in anticipation of
sale. But what if you want to sell off just a part of the business? Or,
what if you want to give away part, as part of your long-term succession
plan?

Minority interest discounts. In family companies, it's
fairly common to have a controlling interest in the company held by the
founder, with smaller blocks of stock held by the children or key
employees. If the entire company will be sold, state laws protect those
holding minority interests and typically require that they will receive
their pro rata share of the sales price. Thus, if the company was valued
at $1,500,000, a 10 percent shareholder should receive $150,000 if the
entire company were sold.

However, if only part of the company is currently being sold or given
away, minority interests are valued at a discount from their pro rata
price. The reason is simply that a minority owner is not likely to have
much influence on the way the company is run. He can't control the board
of directors, control the payment of dividends, or even prevent himself
from being fired if he's an employee.

Exceptions could occur if no one
held a majority interest in the company, or if the company bylaws
specified that a super majority vote (e.g., two-thirds) were required to
take certain actions. But, in most situations, the lack of control
means that the value of a minority interest on the open market is
considerably less than the value of the entire company would suggest.

The IRS recognizes this and will allow a "minority discount" on the
price of the stock. Typical discounts range from 20 to 40 percent,
although greater discounts might be possible depending on the facts of
the situation. In the usual situation, the discount is good news because
it allows the business owner to give away part of the company while
minimizing gift taxes, or to sell part of the company while minimizing
capital gains taxes and allowing the purchaser to buy into the business
at a reasonable cost.

Since tax consequences are so important whenever
business interests are transferred, and since the IRS tends to examine
minority interest values very closely because of the opportunity for
abuse, we strongly suggest that you use the IRS's rules in deciding the
discounted price.

Majority interest premiums. If a minority interest gets
a discount, then you might logically think that a premium should apply
to a majority interest because the interest effectively controls the
corporation. If you thought that, you'd be right. Majority interests,
when sold or given away, are typically valued at more than their pro
rata share of the company's value.

For example, a majority interest of
75 percent of the stock might actually be worth 90 percent of the total
value of the company. A majority interest should never be worth more
than the total company value, however, since those holding minority
interests would always be entitled to something upon sale or liquidation of the company.

If you're planning to pass your business on to the next generation of
your family, carving out minority interests and giving or selling them
to your successors can be a good way to reduce your estate or capital
gains taxes.